What’s the average annual return you expect to get from your investments between now and retirement? Here’s the bad news: if you’re anywhere near as optimistic as the average investor, you’re likely to be disappointed. One American financial newsletter editor recently asked his subscribers for their forecast “net-net-net” return – in other words, what they expected to make each year after inflation, trading costs and tax. The average answer was 6%.
To which Jason Zweig in The Wall Street Journal asks: “What are we smoking and when will we stop?” It may sound low, but 6% is in fact hugely optimistic. According to Ibbotson Associates, US stocks have earned an average annual gross return of 9.8% in the past (the figure for British stocks is slightly lower).
There’s nothing wrong with that. But then you have to account for the fact that inflation, historically, has knocked around 3% a year off returns. Expenses such as trading charges and bid-to-offer spreads knock off another 1%-2%. Then there’s tax, which on shares in Britain includes stamp duty (at 0.5%), capital-gains tax on profits (at 18%) and income tax on dividends (at up to 40%). In the end, the true “net-net-net” return is more like 4%. And that’s if you’re fully invested in shares. Split your investments between shares and safer investments, such as bonds, and that figure could drop to 2%.
Why does this matter? Because if we have hopelessly unrealistic expectations about how rapidly our savings will grow, then we’re probably saving too little for our retirement. The end result is “more years working rather than putting our feet up”.
And this over-optimism afflicts ‘expert’ investors too. David Salem, president of the Investment Fund for Foundations (which manages around $8bn), asked its clients this question: “what guaranteed annual ‘net-net-net’ return would you require for the next 50 years, in exchange for all of your current wealth?” The average answer was 7.4%. In other words, despite all the evidence to the contrary, these investment professionals believed they could earn at least 7.4% by themselves – if not they’d have named a lower swap rate (defined on page 45). One investor even demanded 22%, enough to turn $100,000 into $2.1bn. Yet when the same question was put to London Business School Professor Elroy Dimson – an expert on the history of market returns – he replied with just 0.5%. So what to do?
First, assume any financial adviser who claims to be able to make say 6% a year after costs is either “a fool or a crook”, says Zweig. Ask potential advisers the swap question. What rate would they guarantee you in return for all of your existing assets? If nothing else, it might focus their minds on the returns they believe they can genuinely achieve.
Next, take full advantage of any tax reliefs you have. Use your annual Individual Savings Account allowance and your capital-gains tax allowance where possible. And if you’re a higher-rate taxpayer, make sure you’re benefiting from higher-rate tax relief on any pension contributions you make. Finally, save more. For example, if you plan to retire on a £1m pot after 20 years, you’ll need to save around £2,164 a month if you expect a gross annual return of 6%. But at Dimson’s 0.5% ‘net-net-net’ rate, that almost doubles to £3,962 per month. Sadly, he’s more likely to be right.
Steer clear of lunatics
Forget ratios, or drawing lines on charts. According to Macquarie Securities, making money in the markets is just a matter of watching the moon. After “scrutinising data from 32 leading indices over several decades”, analysts found that “market cycles move in phase with the moon”, says Leo Lewis in The Times.
It seems equity markets are “a particularly sensitive barometer for the invisible impact of lunar cycles on human psychology”. So much so that, “without exception”, every stockmarket studied showed “a very slight increase in the average return over the new moon period”.
Meanwhile, Asian broker CLSA notes that the near collapse in the financial system was presaged by the lunar cycle. In fact, the true panic of 2008 began on the 27th day of the seventh lunar cycle, the same phase that marked the peak of the market panics in 1857, 1907, 1929, 1987 and 1997. Since we know 2010’s full moon dates (the next one is 14 February), making money in 2010 should be a mere matter of timing your investments to correspond.
If only it were that simple. But as Robert T Carroll says on Skepdic.com, a 1996 study by three professors that reviewed over 100 studies on claimed lunar effects found “no reliable and significant correlation” between the full moon and any form of human behaviour.
Yet lunar myths persist – why? Partly it’s down to media interest (lunar patterns are more fun than ratios). But the biggest culprit is “confirmation bias”. Investors seek evidence that supports their beliefs. Find a market crash and a lunar phase that matches it and bingo, a link is established. But lunar phases happen so frequently that they’re bound to coincide with a crash or other big event fairly regularly. We’d stick with fundamental analysis.